This is the first book that takes an in-depth look at the connection between politics and banking crises. What led you to the topic?

Stephen Haber at Stanford and I spent the better part of the last 30 years working separately on issues of banking system risk. And that work kept revealing the impact of political influences on banking systems.

If you talk to anyone who’s ever run a bank, or any journalist who covers banking in depth, they’ll tell you that politics is hugely important. Yet in a lot of academic analyses, politics is little more than a footnote. We wanted to know — especially in light of the most recent crisis, but also of the last 35 years, in which over a hundred countries — including countries as different as England, Russia, Argentina, and Iceland — have experienced banking crises, why banking systems are sometimes dysfunctional and sometimes successful, and why some countries manage to make transitions from dysfunctional systems to functional ones.

And we wondered if politics was critical to understanding that. And so we began to examine various countries’ banking histories in light of their political histories: where a country’s constitution came from, how it was settled, what system of government it has. We saw that these factors might be the main drivers of banking function or dysfunction, both in terms of instability and scarce credit. Having researched this subject for three decades, we knew that this was more than plausible. It was the story.

How did you test your theory?

We argue that narrative historical analysis, disciplined by economic theory and political theory, can show how political systems work. And we claim that our book is the evidence — that by making a careful examination of historical events and using analytical tools, you can actually learn how politics affect banking outcomes.

We looked at Brazil, Canada, England, Mexico, and the United States. And from these five histories, going back between 200 and 400 years, we were able to understand how political regimes influence banking systems and the extent to which these systems are successful.

The contrasting histories of the United States and Canada are very surprising. While the United States has had 17 severe banking crises, Canada has had only two minor ones, most recently in 1839.

And that minor 1839 crisis was just a spillover effect from the United States. Canada has never had a major panic, which can be explained by its political history.

While America was building a very decentralized national government, Canada was doing the opposite: its banking system was nationally chartered and centralized—unlike the United States, in which small, independent banks — unit banks — served local communities. Also, importantly, not every public official in Canada is elected; senators are appointed. This system, with all of its interesting checks and balances, tends to be relatively immune to populist influence. By populist influence, I’m referring to vested interests that get together within a democracy and try to push for rules that benefit them, such as small banks and rural populists, which joined forces to successfully prevent branching even within states in most of the country for two centuries. James Madison, one of our country’s founders, called these interests factions. Canada’s democracy was designed with constitutional “veto gates” that effectively prevent populist coalitions from taking control of its economic policy.

Another element that may surprise people is the extent to which unlikely coalitions have been responsible for much of the instability of the US banking system.

Populist factions have been the driver in the United States since the early 1800s. The identities of those factions have changed over time, but what happens is a group gets together with another group, and says, We can think of some banking rules that would be great for us. And it doesn’t matter that these rules will make the banking system a lot less stable. In our book, we call this the Game of Bank Bargains.

First we had the agrarian and unit bank coalition, beginning around 1810, which worked together to oppose branch banking. [The unit banks were small and independent, and didn’t want to compete with national branch banks.] That started to become less powerful as the number of people living in rural areas fell. But from about 1810 until 1994, the United States limited large-scale bank consolidation and branching across or within states.

This coalition began to crumble in the 1980s. Many influences contributed to that change. One was the savings and loan crisis. It meant that the federal government, particularly the Federal Deposit Insurance Corporation (FDIC), was facing a big bill because these small, fragile banks were falling apart, and who was going to pay? Out step a few bankers in states like Ohio and North Carolina and California, which allowed some in-state branching. These bankers told the FDIC they’d take some of this problem off their hands if the government would relax the rules and allow branching across state lines.

So the FDIC, the Fed, and the politicians started seeing the advantages. And once the regulators allowed acquisitions of smaller banks by their larger competitors, these growing banks became more powerful in the political process. But that doesn’t mean the United States became Canada, with a chartered, centralized banking system. Instead, the United States set up an approval process that gave local communities an unspecified voice in determining whether banks that wanted to merge were good citizens.

That might sound like a good idea, but I don’t know any economists who think so. Because all of a sudden we had this new highly politicized process, with the Fed stuck in the middle. And organized urban activist groups were trying to define whether a bank was a good citizen, and I’m not joking when I say the main criterion was how much money the banks gave them. The banks actually wrote contracts with these community groups as an explicit quid pro quo for getting the groups to show up at the Fed hearings and testify in their favor. From 1992 to 2006, these banks passed $867 billion to these groups at the time they were seeking approval for pending mergers (the total amount passed to the groups during the period was about $2.5 trillion). The payments were mostly in the form of lending, which these groups funneled as subsidized credit, generally to poor people living in urban areas.

You resist making any specific policy recommendations. Why?

In a book arguing that political coalitions will decide the answers, not economists, it would be strange to make policy recommendations. Of course, I do often make policy recommendations in other work, but in doing so I recognize that good policy ideas eventually get adopted only if political seismic shifts happen that make the system amenable to it. That happened in Brazil in the late 1980s, when shifts in politics made the banking system much more successful. It happened in Mexico in the 1990s. It happened in the UK in 1970s and the 1980s. Fundamental political shifts can create windows of opportunity for good ideas. But what economists can’t do — and they shouldn’t fool themselves about it — is produce these political shifts.

As economists, we’re saying, Look, some countries know how to design a political system with appropriate checks and balances that produces a stable banking system with abundant credit. They’ve been doing it in Canada for 200 years, and maybe we could adapt some of their ideas. But the key question for the United States is whether we’ll see the political shifts that would make better policy possible. I’m not optimistic, but I’m not saying it can’t happen. I like to joke that on Mondays, Wednesdays, and Fridays, I write policy proposals. On Tuesdays, Thursdays, and Saturdays, I write about political economies and show how economists’ policy proposals are irrelevant. And on Sundays, I just pray.

Charles Calomirisis the Henry Kaufman Professor of Financial Institutions in the Finance and Economics Division and curriculum director at the Program for Financial Studies at Columbia Business School.

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Charles Calomiris is the Henry Kaufman Professor of Financial Institutions at the Columbia University Graduate School of Business and a professor at Columbia's School of International and Public Affairs. Professor Calomiris is a member of the Shadow Open Market Committee, the Financial Economists Roundtable, and the Advisory Scientific Committee of the European Systemic Risk Board. He is a Research Associate of the National Bureau of...

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